How Return of Capital Mutual Fund Distributions Are Taxed

Mutual funds sometimes make distributions to shareholders that are not attributable to the fund's earnings. These are nontaxable distributions, also known as returns of capital.

Because a return of capital is a return of part of your investment, it is not taxable. Your mutual fund will show any return of capital on Form 1099-DIV in the box for nontaxable distributions.

If you receive a return of capital distribution, your basis in the shares is reduced by the amount of the return.

Example: In 2000, you purchased 100 shares of Fund ABC at $10 a share. In 2001, you received a $1-per-share return of capital distribution, which reduced your basis in those shares by $1, to give you an adjusted basis of $9 per share. In 2002, you sell your 100 shares for $15 a share. Assuming no other transactions during this period, you would have a capital gain in 2002 of $6 a share ($15-$9) for a total reported capital gain of $600.

Nontaxable distributions cannot reduce your basis below zero. If you receive returns of capital that, taken together, exceed your original basis, you must report the excess as a long term capital gain.

Note: Nontaxable distributions are not the same as the tax-exempt dividends. Tax exempt dividends aren't taxable and don't affect basis.